This was passed on to me by a SI member
INVESTMENT Update/November
Stock Market performance from September 1 through October was simply awful. At it's worst, the S&P 500 declined 13%. The technology laden NASDAQ dropped 27%. Commentators were heard regularly on the investment- focused media shows raising questions about the likelihood of recession and how we must seriously consider whether or not the bull market is over. Investors always worry over something. The most prominent concern at the moment is the deceleration in profit growth expectations. I would rather this be the concern that the Federal Reserve raising interest rates, which was the worry during the first half of 2000. This Update focuses on the short-term concerns that seem to be impacting the market.
Present Market Issues: The FED plus the four e's
Federal Reserve The Fed's potential to further disrupt the market is not a new concern, as it has raised interest rates six times over the past year or so. Present economic data simply does not support further interest rate increases. The economy's growth is moderating. Higher gasoline and heating prices are doing the Fed's work of slowing the economy. Inflation rates are not alarming. Productivity gains are strong which offset most worker's wage gains. We do not believe that the Fed would increase inetrest rates in the face of soaring energy costs. What will be the Fed's response to the energy's impact on the Consumer Price index? While the rise in energy costs already has impacted the CPI and will raise further the reported inflation rate, we view the rise in energy costs as deflationary. Higher prices for energy are slowing growth in the US and even more so in other parts of the world. A further rise in interest rates by the Fed will not diminish energy's impact on the CPI. Having the Fed out on the sidelines, at least for the next few months is very positive compared to conditions earlier this year. Fed's action next year does remain a threat as it is not yet in the mood to begin reducing interest rates.
Euro's weakness: The US economy has been growing faster than Europe's and short term interest rates are higher in the US. With these conditions, it is typical for a country's currency to stregnthen from capitol inflows. In addition, substantial European money is flowing to the US, both to make acquisitions and to purchase US stocks. These actions require selling euros and buying US dollars. Recently, as much capitol flow has occurred in a month as in the whole of 1996. These investments reflect the growth opportunity in the US, particularly in technology. If you want to be invested in leading technology companies, you must be invested here.
Investors are worried that the US multinationals will suffer an earnings short fall because of the declining euro. Profits made in Europe are worth less in dollars. Virtually all the major companies hedge this risk. The euro's decline is having a sales impact on US products, which have become relatively more expensive. Profits from Europe represent about 10-12% of S&P 500 companies' earnings. For a few companies the exposure is in excess of 25%. The euro's weakness may reduce earnings growth of the S&P 500 companies by two to three percentage points. It is impossible to determine when a currency has hit bottom, but the euro's decline has been so substantial that further vulnerability should be limited.
Energy costs: Investors are concerned about the impact of rising energy costs on the economy. Demand for energy has been very high because of world growth. Most recently, Middle East violence has increased the possibility of a further spike in energy prices . Energy price increases function like tax increases - perhaps $500 or more on the average family. Essentially, income flows from US consumers of energy to foreign producers in proportion to the rise in prices and the volume of petroleum imports. We do not believe that the direct impact on the US economy is either large enough to derail its growth or nearly as great as the spike in prices suggests. Established contract prices are subject to much less fluctuations than the daily market quotes for oil. Furthermore, the futures quotes for energy suggest that prices will be lower over the next year. If the economy were going to grow at 4%, perhaps the direct impact of the rising cost of energy would subtract 0.3%. Obviously, Middle East events, which have given rise to greater uncertainty, could change this outlook. The greatest risk may be that consumer confidence is impacted, causing a pull back in spending. This indirect impact presents a more significant threat to economic growth, but we do not believe that the present circumstances of the economy or inflation are at all comparable to the 1970s.
Earnings: Earlier in the year, investors were primarily concerned about the Fed's actions. The foremost worry now is slowing profit growth which ties together the previous concerns of higher interest rates, energy and the euro. The impact of each is to slow the economy's growth. Given the exceptional vigor of the economy in the first half of 2000, profits have been expected to slow . Economic decceleration is a positive, as long as the slow down is not severe, in that it does not remove the Fed as a major concern. But, earnings growth is going to be slower than the experience of the last few quarters. I do not think that the issue is so much that earnings reports are awful but that expectations and valuations have been unsustainably high. Analysts were expecting third quarter profits growth to maintain the level of the first two quarters of 2000. Clearly that could not be the case given the impact of higher energy costs, the euro, and the slowing economy.
The profit problem has existed more with individual companies falling short of expectations. It has been
particularly upsetting to investors that several high profile companies like Home Depot fell below expectations. Prior to the normal reporting period, companies have been pre-announcing their profit shortfall relative to analysts' expectations . Almost by definition, the news announced at this time is negative. The affected companies instantly may take a 20-40% haircut in their stock prices. We now are through this pre-announcement activity. As actual earnings are reported, I believe investors will gain more confidence that overall corporate profits are not falling off the table. Incidentally, the number of negative pre-announcments was not much higher than those in recent years.
The rapid pace of innovation is the fuel for the productivity spurt that raises the speed limit for economic growth without boosting inflation. The process of creative destruction means that some previous innovators will fail to adapt. The risks for individual companies have risen as innovation has become more rapid. In response, interest rate spreads between lower and higher quality bonds has risen. Junk bond spreads have risen sharply. Banks are signaling an increase in non-performing loans. All this is occurring in what has been a period of exceptional growth. Some slowing of growth, given very competitive business conditions, is impacting the financial health of overly leveraged companies that are not innovating. Both stock and coporate bond selections within industries are much more important now than a few years ago when the rising tides of the markets was rising almost all boats. As long as productivity remains at a high level, we do not believe that the process of creative destruction signals a problem with overall corporate profits. Should technology spending slow markedly, we would be very concerned that productivity could be sustained at a level necessary to maintain profit margins.
Election The uncretainty of the elections has investors more concerned than the election's potential outcome. No galvanized issues have voters particularly energized. Thus, more watched the final episode of Survivor than will vote. Our founding fathers devised a system of government with checks and balances. This makes it difficult to pass bad policy. In recent years, gridlock has been wonderful. It will be difficult for politicians to ignore the wished of shareholders, whose numbers are very large and whose interest in the market is very substantial.
Summary
Having the Fed out of the way for at least a few months has improved the investment environment. Presently, this advantage is being more than offset by investors adjusting to a deceleration in profit growth expectations. The economy appears to be in good shape, sufficiently strong to withstand current concerns. Profit growth has been strong, although deceleration is expected. The major change of recent weeks is the decline in stock prices, which has improved equity valuations.
We believe that the longer term forces driving the bull market in stocks to remain in place. The wave of innovation is allowing productivity to reach levels far above recent decades. Thus, the speed limit for growth has been increased. The US economy is more stable and is likely to experience recession caused by unpredictable external events. Inflation will remain low aided by the resolve of the world monetary authorities, very competitive business conditions and the impact of technology. Investors' equity mania is not likely to be disturbed without a prolonged and deep bear market. Investors adjust to the short-term issues discussed above before these longer-term forces again become most prominent in their minds.
H. Vernon Winters
Chief Investment Officer
Mellon Private Asset Management |
